Investors Should Beware of Optimistic Executives

It's a phenomenon we all remember from the financial crisis. A chief executive of a major financial company would take to the airwaves to proclaim the health of his own company—and the market would immediately balk, sending stock prices down even further.

Was this a sign of irrational panic? That's what a lot of corporate spokesmen would have you believe. They argued until they were weak in the gums that corporate insiders understood their companies better than guttersnipe short-sellers or gloomy bloggers.

A new paper by Catherine Schrand, Professor of Accounting at the University of Pennsylvania, and Sarah Zechman of the accounting group at the University of Chicago Booth School of Business, however, suggests that markets are wise to be wary of optimistic executives.

The scholars looked at 49 firms sanctioned by the SEC for financial misreporting. What they found is that only a quarter of the misstatements involve executives intentionally committing corporate fraud. The other three-quarters were mistakes that began as small and possibly unintentional errors that stemmed from an optimistic bias. Worse, as subsequent earnings shortfalls hit, firms compounded the trouble by making more misstatements.

One problem, however, is that overconfidence is also a key to the success of CEOs. Is there a way to monitor overconfident CEOs so that they produce better-than-expected results but don't fudge things when results aren't up to snuff? What's more costly, a) monitoring the overconfident, b) excluding the over-confident, or c) tolerating misstatements?

In any case, it shouldn't be surprising to anyone that markets do not always believe CEOs of companies that appear to be under stress. As the study shows, overconfident CEOs are prone to mistakes.